Volatility Signals Growing Investor Concern, But No Panic

Stocks go down, volatility goes up. That's a pattern we've seen time and time again in the financial markets, and this time is no different following the Brexit shocker last week.

As the S&P 500 tanked 3.6% on Friday, the CBOE Volatility Index (VIX) shot up nearly 50% to 26―a four-month high. Similarly, the Bats-T3 SPY Volatility Index (SPYIX) jumped 44% to around 25.

At those levels, both volatility indexes nearly doubled from their lows of 13 from earlier in the month.

Year-to-Date VIX (Blue) & SPYIX (Orange) Through Friday

Implied Volatility: The Market's Fear Gauge

The VIX is widely considered the stock market's "fear gauge," because it rises when traders and investors are willing to pay more to hedge their positions.

The CBOE index attempts to measure volatility based on the pricing of S&P 500 stock index options. When investors are willing to pay more for options, they expect larger moves in the market (and vice versa). This is called "implied volatility."

Meanwhile, up-and-coming SPYIX measures implied volatility based on the pricing of options on the SPDR S&P 500 (SPY | A-97), the ETF that tracks the S&P 500.

SPYIX was launched this year as a competitor to VIX, and reflects the growing importance of ETFs in the options markets. SPYIX is calculated by T3 Index and Bats Global Markets, which owns ETF.com.

Investors Concerned, But Not Panicking

Current levels in the volatility indexes reflect investors' understandable concern following Brexit. How the situation impacts the global economy is highly uncertain, with some analysts sounding dire warnings and others suggesting the event won't have much of an impact at all.

At levels in the mid-20s, the VIX and SPYIX reflect modest levels of investor worry, but it would take a spike above 30 before these indexes signal panic among investors.

Since last August, there have been two major corrections in the U.S. stock market, and each saw implied volatility spike to more than 30 at one point. In the August 2015 sell-off, the VIX topped 53; in the swoon from January of this year, the VIX surpassed 32.

VIX (Since 2014)

If the current drop in the S&P 500 grows into something bigger, expect the "fear gauge" to spike more from here.

19 Volatility ETFs

In the ETF world, there are currently 19 products tied to volatility. The largest by far is the iPath S&P 500 VIX Short-Term Futures ETN (VXX | B-47), with $1.8 billion in assets.

VXX gets its exposure to implied volatility by tracking short-term VIX futures. As always, the use of futures by an exchange-traded product creates unique considerations for investors such as roll costs from contango (or roll yields from backwardation).

Additionally, while spot VIX (the number quoted by the financial press) and VIX futures tend to move in the same direction, they may not move one-for-one on any given day, particularly if futures traders believe that the spike in spot VIX will be short-lived.

For example, when spot VIX spiked 49% last Friday, front-month VIX futures (July expiration) rose by 36%; second-month VIX futures (August expiration) rose by 26%; and VXX―which holds a combination of July and August futures―rose by 24%.

Leveraged VIX Products

Aside from VXX, there are a handful of other volatility products with respectable asset bases. The ProShares Ultra VIX Short-Term Futures ETF (UVXY), with $1.1 billion in AUM, provides 2x-leveraged exposure to short-term VIX futures.

In addition to contango and backwardation, traders of leveraged products such as UVXY must be mindful of the performance drag that comes from daily rebalancing.

These products are most suitable for traders and hedgers with extremely short holding periods. On Friday, UVXY surged 44%, nearly matching the return on spot VIX. A similar product, the VelocityShares Daily 2x VIX Short-Term ETN (TVIX), also performed well on Friday, gaining 41%.

Midterm VIX Products

Another group of volatility products are those that target the middle of the VIX futures curve. The iPath S&P 500 VIX Mid-Term Futures ETN (VXZ | B-37), with $52 million in assets, tracks VIX futures that have an expiration date five months out, on average.

This makes returns for products such as VXZ much less volatile, and thus could make them more suitable for longer-term holding periods.

On Friday, for example, VXZ rose about 9.5%.

Inverse VIX Products

Some of the most popular volatility exchange-traded products are those that provide inverse exposure to the VIX. Combined, the VelocityShares Daily Inverse VIX Short-Term ETN (XIV) and the ProShares Short VIX Short-Term Futures ETF (SVXY) have about $1.2 billion in assets under management.

As inverse products, XIV and SVXY rise when the VIX falls, and fall when the VIX rises. For traders betting that ‘Brexit’ won't be the catastrophe that many fear, inverse VIX products may be worth considering.

Unsurprisingly, last Friday was a dismal day for these products, with losses of more than 26% each.

Daily Performance of Spot VIX & Various ETPs on Friday, June 24

Contact Sumit Roy at [email protected].